The KML to SHP tool was designed to read kml files generated by Google Earth (GE) v4.2. Kml files generated by earlier versions of Google Earth or other software may have different formats and will be unreadable by the tool. If you have kml files that may have older formats, then you can load the file into Google Earth 4.2 and then resave it as a kml file. This should create a kml file in a format that can be read by the tool. The tool cannot read kmz files.
Kml files can be created from any features digitized in Google Earth. For convenience, all features should be contained in the same folder in the Google Earth table of contents. The entire folder can then be saved as a kml file. The KML to SHP tool will create a shapefile from features of the specified type (polygon, line, point) extracted from the kml file. The shapefile will be in geographic coordinates and can be projected to the desired coordinate system using the Data Management Tools > Projections and Transformations > Feature > Project tool in ArcToolbox.
Before running the KML to SHP tool, you must first add the KML_to_Shp.tbx to ArcToolbox. The tool documentation gives details on how to use it - see the help column of the tool dialog window. The Importing Google Earth Data into a GIS PowerPoint presentation provides a detailed overview of the tool as well as tips for using Google Earth screen captures as reference imagery in ArcGIS.
